How a Private Equity Fund is formed and run
A private equity fund is a collective investment scheme used for making investments in various equity (and to a lesser extent debt) securities according to one of the investment strategies associated with private equity. Private equity funds are typically limited partnerships with a fixed term of 10 years (often with annual extensions). At inception, institutional investors make an unfunded commitment to the limited partnership, which is then drawn over the term of the fund. From investors point of view funds can be traditional where all the investors invest with equal terms or asymmetric where different investors have different terms.
A private equity fund is raised and managed by investment professionals of a specific private equity firm (the general partner and investment advisor). Typically, a single private equity firm will manage a series of distinct private equity funds and will attempt to raise a new fund every 3 to 5 years as the previous fund is fully invested.
Most private equity funds are structured as limited partnerships and are governed by the terms set forth in the limited partnership agreement or LPA. Such funds have a general partner (GP), which raises capital from cash-rich institutional investors, such as pension plans, universities, insurance companies, foundations, endowments, and high net worth individuals, which invest as limited partners (LPs) in the fund. Among the terms set forth in the limited partnership agreement are the following:
Term of the partnership
The partnership is usually a fixed-life investment vehicle that is typically 10 years plus some number of extensions.
An annual payment made by the investors in the fund to the fund's manager to pay for the private equity firm's investment operations (typically 1 to 2% of the committed capital of the fund.
Hurdle rate or preferred return
A minimum rate of return (e.g., 8–12%), which must be achieved before the fund manager can receive any carried interest payments.
A share of the profits of the fund's investments (typically up to 20%), paid to the private equity fund's management company as a performance incentive. The remaining 80% of the profits are paid to the fund's investors.
Transfer of an interest in the fund
Private equity funds are not intended to be transferred or traded; however, they can be transferred to another investor. Typically, such a transfer must receive the consent of and is at the discretion of the fund's manager.
Restrictions on the General Partner
The fund's manager has significant discretion to make investments and control the affairs of the fund. However, the LPA does have certain restrictions and controls and is often limited in the type, size, or geographic focus of investments permitted, and how long the manager is permitted to make new investments.
Private Equity Investments and Financing
A private equity fund typically makes investments in companies (known as portfolio companies). These portfolio company investments are funded with the capital raised from LPs, and may be partially or substantially financed by debt. Some private equity investment transactions can be highly leveraged with debt financing—hence the acronym LBO for "leveraged buy-out". The cash flow from the portfolio company usually provides the source for the repayment of such debt.
Such LBO financing most often comes from commercial banks, although other financial institutions, such as hedge funds and mezzanine funds, may also provide financing. Since mid-2007, debt financing has become much more difficult to obtain for private equity funds than in previous years.
LBO funds commonly acquire most of the equity interests or assets of the portfolio company through a newly created special purpose acquisition subsidiary controlled by the fund, and sometimes as a consortium of several like-minded funds.
Capital Gain or Income : Trump could target 'carried interest' tax loophole.
The Trump administration's push to overhaul tax laws might soon target a loophole used by some financial managers to lower their tax rates, White House Chief of Staff Reince Priebus said on Sunday.
President Donald Trump campaigned before the Nov. 8 election to eliminate the so-called "carried interest" loophole, which is used by many financial managers to lower tax obligations. But a rough outline for a major tax overhaul released last week failed to mention the loophole.
Priebus, however, hinted that carried-interest could be on the chopping block and warned against analysts taking the view that financial managers would keep on benefiting from it.
"Carried interest is on the table," he said. "The president wants to get rid of carried interest so that balloon is not going to stay inflated very long, I assure you of that."
The carried interest rule allows financial managers at private equity, hedge fund and other firms to pay a capital gains tax rate on their income instead of the higher income tax rate.
Alternative investment funds -From Regulatory perspective, investor protection is not the objective as it relates to informed invetors. SEBI is out to do more than just investor protection. It needs to contain systemic risk.Hence this.
Question to SEBI : Your recent regulation was on alternative investment funds such as private equity, venture capital funds and so on. These are vehicles for informed investors. Why the regulation?
Answer: SEBI has two guiding principles. One is investor protection and the other is containing systemic risk. In 2008, large pools of money were used to play the stock market, without anybody even having an idea of the dimension of the problem. If we had the data on these funds, we may have been alerted to the crash. That is why we would like to regulate alternative investment funds. If you are setting up a PE, VC or hedge fund, you cannot collect less than Rs 1 crore. And anyone collecting above Rs 1 crore per investor has to register with us and be regulated.
On investor protection, we are looking at a hierarchy of regulations. For mutual funds, where one can invest Rs 500-1,000, regulations will be tight, as these are uninformed investors. Alternative investments will have light-touch regulations. We have set the threshold at Rs 1 crore. The idea is that the uninformed retail investor will be permitted to invest only in areas where regulation is tight.
So was there a regulatory vacuum in terms of large entities raising money and not being regulated?
Yes. Previously there was no requirement that all venture funds must register with SEBI. Now that has been changed. All venture capital funds which raise domestic money need to be registered with us. The concept is that if anyone is raising money in India they need to be registered with us. If they don't register, they are violating rules.
To give an example, in 2005, 2006 and 2007, many firms raised money for real-estate. They pooled small sums of money such as Rs 5 lakh and that went into real-estate funds. Now, even for activities like that, the minimum investment is Rs 1 crore. Now, some people may not be happy with that. But we feel that these vehicles are not suitable for small investors.
The original concept paper asked alternative funds to register under seven categories. You have now reduced that to three broader categories. Why?
We felt that administrating the seven categories will pose a problem. Besides, the firms felt that water-tight compartments will restrict their mandate.
Therefore, we tweaked this based on whether alternate funds get some concessions from the government. Venture funds invest mainly in unlisted securities. They get regulatory forbearance, for instance, a pass-through status on taxes because we feel they are a good means to promote entrepreneurship. The second category is private equity, which can invest in public securities. They too get certain facilities from the government. These two categories need to accept restrictions, they can't use leverage.
The third category is hedge funds, which don't get any facilities from the government and are allowed to leverage. Hedge funds globally do rely on leverage and to restrict this would be not be in keeping with trends across the world.
However having said this, we have to watch the extent to which they are allowed to borrow and the size of such funds in the Indian market. For this they need to be registered. For instance in 2006, 2007, many such firms raised $ 1-2 billion funds and nobody did much about them. But this applies only to funds raising money from Indian investors. Hedge funds and others who raise money from abroad will come under the FII regulations.
You spoke of filling the regulatory vacuum. What about collective investment schemes such as teak schemes, gold bonds and so on?
Yes I agree there are grey areas there. Now, collective investment schemes are to be regulated by SEBI. But we find that very few schemes are willing to submit themselves; they usually claim that they are not collective investment schemes. They are generally taking advantage of the Chit Fund Act or are NBFCs.
In one or two States, this activity has been going on in a big way. The money is often collected from remote areas. We have issued orders in some cases against such firms, but they have gone to Court over this. In the case of collective investment schemes, we need clarity on who the enforcement agency is.